The explanation for, and prediction of, CER under the approach developed from conventional economic theory adopts the same assumptions as those in economics-based studies (that is, self-interest drives human behaviour and wealth maximisation). Corporate disclosure (of which social and environmental disclosure is one part) is a means to reduce agency costs (Gray et al., 2001). The ‘agency costs’ were elaborated as ‘contracting costs’, a result of the development of PAT (which recognised the potential for many contracts to play a role in explaining organisational choice) in Watts and Zimmerman (1990, pp. 134-135). The purpose of CER is to minimise future agency/contractual costs that could arise from regulation or legislation. Thus, CER is often regarded as an addition to conventional accounting activity (Gray et al., 1995a; Parker, 2005). Three popular perspectives developed from conventional economic theory have been used in CER studies. They are decision-usefulness, agency theory and PAT. Each is discussed below.
2.2.1Decision-Usefulness
The decision-usefulness theory adopts an efficient capital markets view. It considers corporate social and environmental reporting as a means to satisfy the information needs of financial stakeholders (Parker, 2005). This approach was popular in Western countries in the 1970s and 1980s when theories about motivations for corporate social and environmental reporting were underdeveloped (Mathews, 1997). Gray et al. (1995a) outlines two types of research under the decision-usefulness approach: ‘ranking’ studies and the investigation of information effects on share price behaviour. In ‘ranking’ studies, financial analysts, bankers and others rank various accounting data in order of perceived importance. The other type of research investigates whether the disclosure of corporate social and environmental information influences share price fluctuations.
In general, the decision-usefulness approach to investigating CSR has been unsatisfactory due to inconsistent and inconclusive results. Nevertheless, Gray et al.
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(1995a) argue that despite its limitations, this approach helps contribute to CER research by raising the ‘visibility of non-financial, non-economic factors in organisational reporting and accountability’. Hence, this kind of research adds diversity to the traditional accounting research.
2.2.2Agency theory
Agency theory centres on the agency relationship. This is defined by Jensen and Meckling (1976) as:
…a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent (p. 5)
Because the unit of analysis is the contract governing the relationship between the principal and the agent, agency theory focuses on ‘determining the most efficient contract governing the principal-agent relationship’, given assumptions about people (e.g. self-interest, bounded rationality, risk aversion), organisations (e.g. goal conflict among members), and information (e.g. information as a commodity which can be purchased) (Eisenhardt, 1989, p.57). Developed from information economics, agency theory has two major perspectives: positivist and principal-agent. The former emphasises how capital markets can affect companies. The latter does not refer to capital markets at all. However, Eisenhardt (1989) argues that the two streams are convergent in terms of the unit of analysis (agency relationship and the assumption about human behaviours, organisations, and information, and hence they are complementary. A positivist perspective identifies various contract alternatives. A principal-agent perspective indicates which contract is the most efficient under varying levels of outcome uncertainty, risk aversion, information and other variables.
Agency theory provides a positivist perspective in accounting research. It regards the motivation for corporate social and environmental reporting as increasing management welfare (Ness & Mirza, 1991), or forestalling future agency costs arising from legislation or regulation (Gray et al., 1995a). Jensen and Meckling (1976) describe agency costs as the ‘sum of monitoring expenditures by the principal, bonding
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expenditures by the agent, and residual loss’. They argue that organisations serve as a nexus for a set of contracting relationships among individuals and that the agency costs exist for all the contractual relations in an organisation, not only with employees but with suppliers, customers, creditors, too.
Agency theory is popular in business analysis. However, it is still controversial (Eisenhardt, 1989). Proponents claim that agency theory provides a framework that explicitly incorporates conflicts of interest, incentive problems, and mechanisms for controlling incentive problems into analysis (Ness & Mirza, 1991). Opponents argue that agency theory is morally wrong and inconsistent with the agenda of corporate social and environmental accounting, whose objective is to achieve accountability and transparency for social wellbeing (Gray et al., 1995a). Jensen and Meckling (1976) contend a serious limitation of agency theory is its application to the very large modern corporation whose managers own little or no equity.
2.2.3Positive Accounting Theory (PAT)
PAT is a theory:
…concerned with explaining accounting practice. It is designed to explain and predict which firms will and which firms will not use a particular method of valuing assets, but it says nothing as to which method a firm should use (Watts & Zimmerman, 1986, p.7)
PAT adopts the concept of positive theory commonly used in economic theory of property rights, the agency relationship, and regulation that assumes non-zero information, lobbying, and coalition costs (Watts & Zimmerman, 1986, pp. 220–222). The Efficient Market Hypothesis (EMH) and Capital Assets Pricing Model (CAPM) have had a strong influence on the development of PAT. The theory assumes there are efficient capital markets which react in an efficient and unbiased manner to publicly available information. Security prices reflect the information content of publicly available information. This information is not restricted to accounting disclosures. Valuing the firm requires estimates of the firm’s expected future cash flows and risk. PAT also views the firm as a nexus of contracts between self-interested individuals who seek to maximise their own welfare but who also recognise that their own welfare
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depends on the survival of the firm. Thus, firms organise themselves in the most efficient manner, to maximise their survival prospects (Scott, 2009). However, management’s discretion to choose from a set of accounting policies opens the possibility of opportunistic behaviour.
PAT developed three of hypotheses (Watts and Zimmerman, 1986, 1990), namely the bonus plan hypothesis, the debt/equity hypothesis, and the political cost hypothesis to explain and predict management’s incentives to choose accounting methods.
The bonus plan hypothesis is ‘that managers of firms with bonus plans are more likely to choose accounting procedures that shift reported earnings from future periods to the current period’ (Watts & Zimmerman, 1986, p. 208). Such selection will presumably ‘increase the present value of bonuses if the compensation committee of the board of directors does not adjust for the method chosen’ (Watts & Zimmerman, 1990, p.138).
The debt/equity hypothesis states that ‘the larger a firm’s debt/equity ratio, the more likely the firm’s manager is to select accounting procedures that shift reported earnings from future periods to the current period’ (Watts & Zimmerman, 1986, p. 216). That is, to avoid the probability of a covenant violation and of incurring costs from technical default, managers exercise discretion by choosing income–increasing accounting methods to ‘relax debt constraints and reduce the costs of technical default’ (Watts and Zimmerman, 1990, p.139).
The political cost hypothesis states that ‘the larger the firm, the more likely the manager is to choose accounting procedures that defer reported earnings from current to future periods’ (Watts & Zimmerman, 1986, p. 235). Size is often used as a proxy variable for political attention. This hypothesis borrows the concept of political process in economic theories of regulation (Peltzman, 1976; Stigler, 1971): That is, it adopts the assumption of positive information costs and lobbying costs and of self-interest driving an individual’s behaviour. These political costs are a function of reported profits and are part of the costs of contracting in the political process. The extent and form of wealth transfers created by the political process are affected by ‘contracting costs’. Given the cost of information and monitoring, managers have incentive to exercise discretion over accounting profits and the parties in the political process settle for a rational amount ex
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post-opportunism (Watts & Zimmerman, 1990, pp. 133-139). As Watts and Zimmerman (1978) explain, corporations employ several devices, such as ‘social responsibility campaigns in the media, government lobbying and selection of accounting procedures’ to minimise reported earnings. This helps to ‘reduce the likelihood of adverse political actions and, thereby reduce expected costs’ (p.115).
PAT, with its origin in agency theory, was developed originally to explain and predict company accounting choices. However, the direct reference to social disclosure by Watts and Zimmerman (1978, 1979, 1986, 1990) themselves, was extremely limited. Exceptions include a general reference to organisational choice (which may implicitly relate to organisational choice of social and environmental reporting activities as in Watts & Zimmerman, 1990, p. 134) and a brief mention of corporate social responsibility campaigns as an example in the discussion of the political costs hypothesis (Watts & Zimmerman, 1978, p.115). However, precisely how social responsibility campaigns in the media accord with Watts and Zimmerman’s notion of political costs is unclarified. Except for the political cost hypothesis, direct reference to the other two hypotheses of PAT in CER studies is rare. This has led to criticism of applying a PAT perspective to explain CER (such as Gray et al., 1995a; Milne, 2002).